ETFs For ‘Operation Twist’

Ben Bernanke has reiterated on multiple occasions that the Federal Reserve continues to have tools to re-energize the flailing economic recovery.

One of the tools many in the markets expect to be unveiled as early as the next FOMC meeting has been dubbed “Operation Twist.”

In this scenario, the Federal Reserve would flatten the yield curve by shifting bond holdings farther out on the yield curve, helping to raise short-term yields and lower long-term yields on Treasurys. As outlined in a Financial Times article, this scenario can have positive as well as negative effects.

In fact, its overall efficiency is in question as the markets may have already priced in its expected effect. The iPath U.S. Treasury Flattener ETN (NYSEArca: FLAT) can be a good gauge for a top-level view of the changes in the shape of the Treasury curve.

FLAT is effectively short two-year Treasury note futures while being long 10-year Treasury futures. Any increase in long-term yields coupled with a decrease in short-term yields would lead to positive returns.

FLAT’s use of futures as a proxy for the performance of the underlying Treasury bonds makes it a solid measure of expectations.

Both the chart of the year-to-date yields on Treasurys and FLAT’s performance over the past year suggests that the yield curve has recently flattened out. The moves are probably in anticipation of Fed action at its meeting next week, and have led to positive returns.

It’s important to note that FLAT is an ETN with counterparty risk associated with Barclays Bank Plc. Although it’s an inverse fund, FLAT doesn’t suffer from the daily reset feature that creates path dependency for other inverse ETFs. It has an expense ratio of 0.75 percent.

For those not interested in dabbling in ETNs or inverse funds, plain-vanilla options such as the iShares Barclays 20+ Year Treasury Bond Fund (NYSEArca: TLT) are available. TLT carries an expense ratio of 0.15 percent, and is one of six funds in the long-term Treasurys space that would benefit from a continued decrease in yields.

Unlike FLAT, which benefits from the narrowing of the difference between the two- and 10-year Treasury yield spread, TLT would benefit from a downward shift in rates.

TLT simplicity may prove beneficial in the unlikely chance that the Fed surprises the markets with another round of quantitative easing, further expanding its already substantial balance sheet.

On the other hand, all this speculation could be smoke and mirrors. The anticipated action may never materialize, as was the case with the Fed’s Jackson Hole summer retreat, which ended with only vague assurances from the central bank that it had tools at its disposal it could one day mobilize.

In the end, the Fed’s actual ability to enact “Operation Twist” is questionable.

The plan requires demand for short-term Treasurys from outside sources. This may prove problematic, as Treasury yields have been significantly affected by the Greek debt crisis. Should those fears subside, demand for U.S. government debt would probably drop off—and at an inopportune time.

What really happens is anyone’s guess, but investors now, more than ever, have numerous options in the ETF universe on which to place their bets.